What Does Compound Mean?
The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
Also known as "compound interest."
Understanding Compound Interest
Suppose you invest $10,000 into company XYZ. The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $400, because the $2,000 you gained in the first year grew by 20% too. If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for 25 years would grow to nearly $1,000,000 (and that's without adding any money to the investment)!
The power of compounding was said to be deemed the eighth wonder of the world - or so the story goes - by Albert Einstein.
How Compounding Works
The formula for calculating compound interest is:
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
(Where P = Principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.)
Take a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be: $10,000 [(1 + 0.05)3] – 1 = $10,000 [1.157625 – 1] = $1,576.25.
When calculating compound interest, the number of compounding periods makes a significant difference. The basic rule is that the higher the number of compounding periods, the greater the amount of compound interest.
If the number of compounding periods is more than once a year, "i" and "n" must be adjusted accordingly. The "i" must be divided by the number of compounding periods per year, and "n" is the number of compounding periods per year times the loan or deposit’s maturity period in years.
Investor.gov, a website operated by the U.S. Securities and Exchange Commission, offers a free online compound interest calculator. The calculator is fairly simple, but it does allow inputs of monthly additional deposits to principal, which is helpful for calculating earnings where additional monthly savings are being deposited.